Understanding Liquidity

small-business-cash-Flow-planningThe news has been full of headlines regarding the liquidity of the financial markets lately, but what about your business’ liquidity? This is a critically important concept for business owners.

In finance, the term liquidity has a variety of definitions depending upon the context. In a small business, liquidity is a measure of your ability to pay your bills and other obligations.

Short term liquidity is particularly important because it measures your ability to meet current obligations (e.g., payroll, vendor bills, payroll taxes, and interest payments.) If you can’t meet your creditor obligations in a timely manner, you may not be able to obtain credit or purchase vendor services/materials when needed. This will surely impair your ability to do business and can, in some cases, actually put you out of business.

If your accounting books are up to date, you can quickly see how solid your financial position is by doing a little basic math. The Current Ratio and the Quick Ratio are the two measures to use and they are both calculated using the Current Assets and Current Liabilities totals on your Balance Sheet.

Current assets represent cash or assets that can be converted to cash within 12 months. The same is true of current liabilities, which are obligations or bills that will be due within 12 months. So it’s easy to understand why the relationship between these two numbers is important.

The formulas are as follows:

Current Ratio =

Current Assets ÷ Current Liabilities

Quick Ratio =

(Current Assets – Inventory) ÷ Current Liabilities

If the calculations result in positive numbers, you have a healthy result. As an example, if you have a Current Ratio of 2, it means that the value of your current assets is twice as much as your current liabilities. However, a negative result means your short term obligations exceed your ability to pay them, which is a warning sign that you will need to address. 

It is more difficult to obtain a positive result using the Quick Ratio because it excludes the value of your inventory. For this reason, it is often referred to as the “acid test.”  If you operate a business that carries large inventories or is one in which inventory is slow to turn over, it’s good to know that your Quick Ratio is also positive. 

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